Market Efficiency (TUT 2)

2. What would cause a market to be efficient?

A large number of competing profit-maximizing participants analyze and value securities, each independently of the others New information regarding securities comes to the market in a random fashion Profit-maximizing investors cause security prices to adjust rapidly to reflect the effect of new information In a word, Competition makes markets efficient

9. What does the EMH imply for a portfolio manager?

If the portfolio manager has superior analysts then they should concentrate on the areas where the analysts have expertise. Without superior analysts, the portfolio manager can still perform a valuable service. The major efforts of the portfolio manager should be directed toward determining the risk preferences of his clients and offering, accordingly, a portfolio approximating the risk and return desires of the clientele. Second, the portfolio manager should attempt to achieve complete diversification - eliminate all unsystematic risk. Thus, the portfolio should be highly correlated with the market portfolio of risky assets. Finally, it is important to minimize transactions costs - minimize taxes for the client, minimize commissions by reducing trading turnover, and minimizing liquidity costs by only trading currently liquid stocks.

8. What does the EMH imply for a fundamental analyst?

The proponents of fundamental analysis advocate that at one point in time there is a basic intrinsic value for the aggregate stock market, alternative industries, and individual securities and if this intrinsic value is substantially different from the prevailing market value, the investor should make the appropriate investment decision. In the context of the efficient market hypothesis, however, if the determination of the basic intrinsic value is based solely on historical data, it will be of little value in providing above average returns. Alternatively, if the fundamental analyst makes superior projections of the relevant variables influencing stock prices then, in accordance with the efficient market hypothesis, he could expect to outperform the market The implication is that even with an excellent valuation model, if you rely solely on past data, you cannot expect to do better than a buy-and-hold policy. In short, if markets are reasonably semi strong-from efficient, then the fundamental analyst either needs to be very good or have access to information the market doesn't in order to make a consistent abnormal return.

i) Define and discuss the strong-form form EMH. ii) Describe two sets of tests used to examine the strong-form EMH.

i) Information - public and private, new, monopoly (It goes beyond the semi strong-form because it requires that no group of investors have a monopolistic access to any information) Trading strategy - private information analysis Evidence suggests it is possible to make abnormal returns ii) - inside trading - mutual fund performance

3. Define and discuss the weak-form form EMH. Describe two sets of tests used to examine the weak-form EMH.

i) Reflects past prices. • Information - Past price behavior • Trading strategy - Technical analysis • Market efficiency test - weak form --> no relationship between past price changes and future price changes ii) - time series (e.g. Correlation of price changes) - filter rules (e.g. Charting of prices) - technical indicators (e.g. Price/volume changes)

i) Define and discuss the semi strong-form form EMH. ii) Describe two sets of tests used to examine the semi strong-form EMH.

i) The semi strong-form efficient market hypothesis contends that security prices adjust rapidly to the release of all new public information and that prices reflect all public information (includes stock splits, economic news, political news, etc.) Information - published reports and info Trading strategy - Fundamental analysis ii) - event studies (e.g. dividends, splits, earnings, takeovers etc.) - Profitability of trading on public information

12. Interpret the following statements in terms of market efficiency; (a) Shares continue to rise for two weeks after a profit increase is announced. (b) Small firms consistently earn larger returns than large firms. (c) The Australian dollar always falls after Christmas but rises after Australia Day. (d) Shares in the target companies rise before a takeover is announced.

(a) Semi-strong inefficiency (b) Possibly semi-strong inefficiency, but more likely the result that small firms are riskier than large firms. If the small firms are riskier than the large firms then the larger return is consistent with market efficiency. (c) Weak Form inefficiency (idk why, think bcs anamolies are weak form)) (d) Most likely Strong Form inefficiency. Private info (insider)

Misconceptions about market efficiency

- Cannot make a profit (you can given the risk) - Market does not make mistakes (it can under or over react) - Share market is irrational (it may be volatile but it is rational) - Not possible to make an abnormal return (you can, just not consistently)

What is an efficient capital market? (3) Illustrate with an example.

An efficient capital market is one in which (1) prices adjust instantaneously to (2) all available information in an (3) unbiased fashion. For example, if a company announces an unexpectedly large increase in profit, then this information should be impounded in the company's share price within a very short time and there should be no expectation of making abnormal returns by purchasing shares in the company at the new price. Likewise, if the RBA unexpectedly drops interest rates, we would expect Commonwealth Bond prices to rise.

10. Can a market be weak form inefficient, but strong form efficient?

No. If a market is weak form inefficient then it doesn't reflect past price information. This implies it doesn't reflect all available information (hence it can't be strong-form efficient).

11. GJ posts his share tips online every morning. Jim has been following them and has consistently lost 20% PA over the last 5 years. What does this suggest about market efficiency?

Semi-strong market inefficiency. In an efficient share market it should be just as a hard to be a consistent loser as it is a winner. As a strategy, do the opposite of GJ (i.e. buy when he says sell and sell when he says buy) and this should generate a consistent abnormal return.

6. Discuss what is meant by the joint test issue in EMH tests.

Studies on market efficiency are considered to be dual tests of the EMH and a pricing model (e.g. the Capital Asset Pricing Model). These tests involve a joint hypothesis because they consider not only the efficiency of the market, but also are dependent on the asset pricing model that provides the measure of risk used in the test. For example, if a test determines that it is possible to predict future differential risk-adjusted returns, the results could either have been caused by the market being inefficient or because the risk measure is bad thereby providing an incorrect risk-adjusted return.

7. What does the EMH imply for a technical analyst?

The basic premise of technical analysis is that the information dissemination process is slow - thus the adjustment of prices is not immediate but forms a pattern. This view is diametrically opposed to the concept of efficient capital markets, which contends that there is a rapid dissemination process and, therefore, prices reflect all information. Thus, there would be no value to technical analysis because technicians act after the news is made public which would negate its value in an efficient market.